George Osborne is braced to accept a first humiliating defeat for the coalition government at the hands of the EU this week when European finance ministers wave through new rules to control hedge funds in spite of UK opposition and dire warnings from the City of London.

The new chancellor will endure his European baptism of fire with finance ministers from the other 26 member states at the Ecofin meeting in Brussels on Tuesday, where the controversial regulations will be top of the agenda.

Yesterday government sources said Osborne would "not seek to fight" the plans or argue for a further delay, because the UK has no prospect of blocking the legislation's progress.

Instead he is expected politely to put the UK's case that the regulations will impose unnecessarily burdensome restrictions on the operation of UK hedge funds and harm the City, but without any real hope of changing minds.

"There are two ways of playing this," one Brussels official said last night. "Either the UK makes an argument for a delay, which they would probably lose, or they take the hit now and hope that in a few weeks this is forgotten."

The defeat will be all the more embarrassing because it was Liberal Democrat MEPs who helped champion the legislation on a new regulatory framework for hedge funds and the private equity sector, which EU leaders say were partly to blame for the financial crisis.

While the new UK coalition government accepts that greater regulation is necessary, Osborne, like Alistair Darling before him, is concerned at what he sees as over-prescriptive rules on how and where they can operate.

On Friday, Osborne had a telephone conversation with Elena Salgado, finance minister of Spain, which currently holds the EU presidency. Salgado is keen to see progress on the regulations and made that clear to him.

Treasury sources said the regulations would mean that London-based hedge fund managers would be denied the automatic right to operate as they wished in other European capitals such as Paris, Madrid or Frankfurt. "We argue this on the basis of the single market," said a UK source. "If a hedge fund can operate in London, it should be able to operate in the same way in other European centres without facing extra hurdles."

The head of the Alternative Investment Management Association, which represents hedge funds, warned last night that a flawed directive could have disastrous consequences for small businesses and investment across Europe. Andrew Baker, chief executive of AIMA, said: "Of course the hedge fund and private equity industries would be impacted by a flawed directive, but the consequences would be much wider.

"We have already heard how the directive would hit small firms across Europe and make it more difficult for new businesses to be created, and how development banks investing in emerging markets would be affected. Real estate and infrastructure investment in Europe would also be impacted because funds in this sector would also be covered by the directive. We're talking about schools, hospitals, shopping centres – things that affect ordinary EU citizens."

Osborne's problem is that the UK will have no national veto at the Ecofin meeting and so will be unable to block the regulations, which are strongly supported by France, Germany and Spain.

Once they are approved, they will be subject to further negotiations between the Spanish presidency and the European parliament, with a view to ironing out any remaining disagreements. They would then return to Ecofin to be rubber-stamped. It is expected that they would come into force in 2012.

The battle is just one of a series that the coalition government will face with the EU over coming months. Already the European commission is beginning preliminary discussions on a new EU budget for the seven years from 2013 to 2020. It is expected that all the other 26 member states will demand an end to Britain's £2bn budget rebate, which was negotiated by Margaret Thatcher in 1984.

The EU is also examining measures for better economic governance to tackle the bloc's debt crisis. New proposals to give Brussels more "surveillance" powers over national budgets are regarded by most members as vital to tackling the crisis, but will be fiercely resisted by a Tory-led government in London.